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My Next Energy Trade

I'm using options to profit on this energy stock.

Commodity prices have rebounded sharply since the financial crisis, causing widespread cost inflation and wreaking havoc on companies' gross margins. One commodity that has failed to rebound, however, has been natural gas here in the U.S., which is stuck around the same low level from 2009. This has caused much pain to natural-gas producers, but some low-cost providers have managed to continue to perform well despite the environment.

For my next trade, I've decided to buy long-term call options on Ultra Petroleum(NYSE: UPL), one of the low-cost producers of natural gas. This is a bullish strategy in which we hope that the stock price is driven higher before the call expires. It's also a way to participate in the upside of the stock without putting as much capital at risk, though it does risk total capital loss if the stock doesn't go up within my time frame. Specifically, I have chosen to purchase January 2014 $25 calls on Ultra Petroleum.

The businessUltra's main producing assets are 54,000 net acres in the Pinedale and Jonah Fields in Wyoming, and 260,000 net acres in the Marcellus Shale in Pennsylvania. Both the Wyoming and Pennsylvania acreage produce predominantly natural gas. As of the end of last year, the PV-10 of its proved reserves was $5 billion, based on a gas price of $4.05 per mcf. At $5 and $6, the value of the proved reserves goes up to $8.7 billion and $11.6 billion, respectively, which compares favorably with its market cap of just $4.7 billion.

While oil and gas companies cannot control the price of the commodities they sell, they can certainly contain costs on their end. In that arena, Ultra has been performing excellently. From 2007 to 2010, Ultra lowered its spud to total depth from 35 days to less than 15 days in the Pinedale Field. That means it now drills wells more than twice as fast as it did in 2007. This has contributed to well costs lowering in the Pinedale from more than $6 million in 2007 to less than $5 million in 2010.

Controlled costs and capital discipline have led to Ultra becoming one the industry's low-cost leaders of natural gas, allowing Ultra to produce strong cash flows even with $4 natural gas. In 2010, its all-in costs were $2.68 per mcfe, well below the mean of $5.62 per mcfe. More recently, with cost inflation a strong concern among oil and gas companies, Ultra still managed to clock in with a total cost of $2.78 per mcfe in the third quarter.

It's also important to note that Ultra has 129.1 bcf of production for 2012 hedged at an average price of $5.02. Based on how much Ultra spends on drilling capex next year, that's between 44% and 52% of next year's production. In other words, this company, with costs less than $3, has hedged roughly half of next year's production at $5. Looking further out, I expect the company to hedge for gains in 2013 as well.

Diversifying into oilOne big reason for low natural gas prices is the shale gas boom -- emerging plays such as the Marcellus, Barnett, and Haynesville have massively increased companies' reserves. Baker Hughes(NYSE: BHI), one of the largest oil-field-service companies, recently revealed a chart of the largest oil and gas fields in the world as measured by reserves. The Marcellus and Haynesville shales were sixth and eighth on that list, respectively, showing the massive effects of these gas discoveries.

Natural gas consumption is up almost 10% in the U.S. over the past five years, but such huge increases in supply without a proportionate increase in demand is likely to be a drag on prices. This can be relieved by a few factors, such as companies drilling for oil instead of gas, companies easing their drilling programs once they're done preserving their leaseholds (use it or lose it), and using new sources of demand such as liquefied natural gas exports, natural gas power plants, and increased natural gas usage in vehicle fleets.

While huge spikes in demand are not likely to happen immediately, the price should eventually begin to creep up as returns-focused companies diversify away from natural gas. Even Ultra, which has typically only produced natural gas, has been planning its own oil exploration project. The company has amassed 110,000 net acres in the DJ Basin, targeting liquids in the Niobrara shale. This area is home to companies such as EOG Resources(NYSE: EOG), Chesapeake Energy(NYSE: CHK), and Noble Energy(NYSE: NBL), which have targeted the area to increase their oily exposure.

Even Southwestern Energy(NYSE: SWN), another low-cost leader in the natural gas space, has announced its own foray into liquids by accumulating 487,000 net acres in the Lower Smackover Brown Dense formation. After a few years of this type of industry shift, the supply of natural gas should ease and prices should creep back up.

About the strategyIf natural gas prices recover from these dismal levels, the stock will enjoy quite a lot of upside. The January 2014 $25 calls that I've decided to purchase cost $10.60 as of Friday's close. Based on that price, the breakeven on this trade is $35.60 (strike price plus cost of contract). If the stock's able to cross that level, I enjoy big upside thereafter. If the stock stays between $25 and $35.60, I experience partial loss of capital. The worst-case scenario would be a total loss of capital if the stock closes below $25 as it approaches expiration.

This trade is just to buy calls for now, but I could convert this trade into a bull call spread or a diagonal call by selling a higher-strike call option, lowering the cost of the trade while capping some of the upside. For example, I could set up a diagonal call by selling a March 2012 $39 call, which was recently bidding $0.35. That would reduce the cost of the position from $10.60 to $10.25 while capping my upside at $14.

If the stock closes below $39 by March 2012, I keep the entire $0.35 as profit and would certainly look to reestablish the position by writing another out-of-money call to reduce the cost basis of the position even further. If the stock managed to shoot above $39 before expiration, however, I'd likely be forced to unwind the trade for $14, which would net a profit of $3.75, or 36.6%.

It's a delicate balance trying to collect enough income to reduce the cost basis of the position while not capping the upside by too much. If I don't decide to turn this into a more complex position, I could just decide to sell the calls at a profit, or I could exercise the option and buy shares for $25 any time before Jan. 17, 2014. Natural gas prices are currently stagnating, allowing a good entry point into this trade. Going forward, I fully intend to keep this trade going for the full two years to allow the situation to play out.

Foolish bottom lineUltra offers investors a well-run, low-cost provider of natural gas, a safe place to wager on a rise in the price of the commodity. I am betting that natural gas prices are more likely to go up rather than down from current levels, so I am buying long-term call options on the stock to benefit from that outcome.

Paul Chi is an analyst on the Fool's Alpha and Duke Street services. You can follow him on Twitter to stay up-to-date on his latest market commentary. Paul and Matt Argersinger co-manage the Street Fighter portfolio, where they look for cheap, unloved stocks with home run potential. Paul owns shares of Chesapeake Energy. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy and Ultra Petroleum; and creating a position in Southwestern Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.